Global Real Estate ETFs Leave U.S. Funds In Their Dust

As the first half of 2009 draws to a close, it seems that we’re finally starting to see things return to some semblance of normality. Equity markets have rallied sharply since bottoming out in March. Volatility is back within its historical range after hitting record highs over the past year. And politicians in Washington have been able to slowly turn their attention from the economy to other important disagreements, such as how to proceed in Iran, how to reform healthcare, and what to do about America’s dependence on foreign oil. But despite all these green shoots in the economy, U.S. real estate ETFs remains stuck in a rut, lagging far behind global rivals who have enjoyed tremendous rallies in recent months.

Worst Yet To Come?

By most analyst accounts, U.S. REITs have been held in check largely due to fears that the worst of the real estate bear market is yet to come. While home prices have been steadily declining for the better part of two years, residential real estate generally makes up a relatively small percentage of domestic REITs, which tend to be more heavily weighted towards the commercial and industrial sectors. Over the last year, firms in all industries have slashed payroll in an effort to conserve cash and eliminate inefficiencies, resulting in an unemployment rate that will soon reach 10%. In addition to the obvious consequences of rising unemployment (reduced disposable income, declines in consumer confidence, etc.), this trend reduces the demand for commercial real estate, resulting in rising vacancy rates and deteriorating profitability for property owners.

While the unemployment rate has been slowly rising for some time now, there is a fear that this impact has not been fully felt by the commercial real estate sector. Since many firms enter into leases lasting a year or longer, increases in vacancy rates don’t always come in lock step with increases in the unemployment rate, sometimes lagging by a significant amount of time. Some industry analysts fear that vacancy rates could exceed 20% later this year, compared to historical rates that have hovered in the low double digits.

Moreover, the effectiveness of many of the measures implemented by the Obama administration earlier this year to stem rising foreclosure rates will not be fully known for some time. On the other hand, stimulus packages in many foreign countries have been very effective in reversing declining real estate markets. A further collapse in the commercial real estate market could have far-reaching consequences, as many financial institutions maintain heavy exposure to commercial real estate loans. Some analysts are fearful that further upticks in unemployment and office vacancy rates could derail the recovery process later this year. For the time being, this uncertainty is weighing on U.S. real estate ETFs, many of which are down sharply this year.

International Funds Soar

While U.S. real estate markets struggle to find a bottom, global real estate ETFs have made a strong recovery since March, and many are now solidly in the black after the first six months of the year. The most solid gains have come from Asia, led by the Claymore/AlphaShares China Real Estate ETF (TAO), which is up more than 60% so far in 2009. “While the problems in the U.S. residential real estate market are clear, we may have more, and potentially larger problems coming down the pipe in the U.S. commercial real estate market. By contrast, the Chinese real estate market is showing renewed signs of strength,” says Kevin Carter, CEO and Chief Investment Strategist of AlphaShares.

Most international real estate markets fall somewhere between the U.S. and China, showing signs of recovery, albeit not at the tremendous pace of China. iShares FTSE EPRA/NAREIT Asia Fund (IFAS) has relatively limited China exposure, instead tracking real estate markets in Japan, Hong Kong, Australia, and Singapore. This ETF is up nearly 25% in 2009. WisdomTree‘s International Real Estate Fund (DRW) is a more broad-based fund, with holdings in about a dozen countries including France, the UK, Sweden, Belgium, and Germany. DRW is up about 13% year-to-date.

There’s reason to anticipate continued strong performance from international real estate funds going forward, particularly those with a concentration in the Asian markets. “Most of the areas of China that have had real estate overdevelopment are in the south and east of the country – Shanghai, Shenzhen, etc. Remember, China has over 100 cities with 1 million people or more,” notes Carter. “Real estate markets in most of the tier two cities have fared better, and as the country continues to advance its economy, this is where the real money will be made.”

There are some reasons to be optimistic that U.S. REITs will catch up to their international counterparts in the second half of 2009. Unemployment continues to rise, but at a much slower pace than in previous months, making the most common estimates for vacancy rates appear rather pessimistic. And consumer confidence is beginning to return, a fact that could boost the retail sector of the real estate market, a key component of most REIT holdings. But for now uncertainty is the dominant factor, keeping many investors at bay and widening the gap between domestic and international real estate funds.

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